Energy prices and bills - impacts of meeting carbon budgets. Committee on Climate Change December 2014

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1 Energy prices and bills - impacts of meeting carbon budgets Committee on Climate Change December 2014

2 Energy prices and bills impacts of meeting carbon budgets Committee on Climate Change December 2014

3 Preface The Committee on Climate Change (the Committee) is an independent statutory body which was established under the Climate Change Act (2008) to advise UK and devolved administration governments on setting and meeting carbon budgets, and preparing for climate change. Setting carbon budgets In December 2008 we published our first report, Building a low-carbon economy the UK s contribution to tackling climate change, containing our advice on the level of the first three carbon budgets and the 2050 target. This advice was accepted by the Government and legislated by Parliament in May In December 2010, we set out our advice on the fourth carbon budget, covering the period , as required under Section 4 of the Climate Change Act. The fourth carbon budget was legislated in June 2011 at the level that we recommended. In April 2013 we published advice on reducing the UK s carbon footprint and managing competitiveness risks. In November and December 2013 we published, in two parts, our review of the fourth carbon budget, as required under Section 22 of the Climate Change Act, as an input to the Government s decision in 2014 not to amend that budget. Progress meeting carbon budgets The Climate Change Act requires that we report annually to Parliament on progress meeting carbon budgets. We have published six progress reports in October 2009, June 2010, June 2011, June 2012, June 2013 and July Advice requested by Government We provide ad-hoc advice in response to requests by the Government and the devolved administrations. Under a process set out in the Climate Change Act, we have advised on reducing UK aviation emissions, Scottish emissions reduction targets, UK support for low-carbon technology innovation, design of the Carbon Reduction Commitment, renewable energy ambition, bioenergy, and the role of local authorities. In September 2010, July 2011, July 2012, July 2013 and July 2014, we published advice on adaptation, assessing how well prepared the UK is to deal with the impacts of climate change. The Committee The members of the Committee are the Rt. Hon John Gummer, Lord Deben (Chairman), Professor Samuel Fankhauser, Sir Brian Hoskins, Paul Johnson, Professor Dame Julia King, Lord Krebs, Lord May and Professor Jim Skea. The Chief Executive is Matthew Bell. The Committee would like to thank the core team involved in preparing the analysis for this report: Ute Collier, Adrian Gault, Taro Hallworth, Mike Hemsley, Jenny Hill, Alex Kazaglis, Clare Pinder, Indra Thillainathan, and Mike Thompson. The Committee would also like to thank other members of the team who provided support: Owen Bellamy, Kathryn Humphrey, Nisha Pawar, David Thompson, Steve Smith and Jack Snape.

4 Contents Executive summary and key messages Estimating the impact of carbon budgets on energy prices Household energy bills Commercial sector energy bills Industrial energy bills Acronyms... 90

5 Executive summary and key messages The Climate Change Act 2008 requires us, when advising the Government and Parliament on how to achieve UK emission reductions, to consider economic and social circumstances. This includes the impact on fuel poverty and competitiveness. For that reason, we previously published, in 2011 and 2012, analysis about the impact of low-carbon policies on energy prices and bills. Since then, there has been considerable debate and new developments to take into account. In 2015, we are due to publish our advice to Government on the fifth carbon budget ( ). Ahead of that, this report sets out the facts about the links between climate policy and energy prices and bills. Energy bills for households and businesses have risen in the last ten years. Household bills increased from 650 in 2004 to 1,140 in 2013: that is a 75% increase over a period when there was general price inflation of 23%. We find that most (80%) of this increase has been due to factors unrelated to low-carbon policies. During the same period, there was a reduction in energy consumption, without which bills would have increased a further 165 to 1,305. For a typical dual-fuel household (see Box 1), the 2013 bill was composed of: 1,025 associated with costs of wholesale energy and system costs unrelated to low-carbon policy. 45 associated with support for low-carbon power generation and the carbon price. 60 due to support for energy efficiency schemes and smart meter roll-out, as well as 10 to support low-income households through the Warm Home Discount. Meeting the UK s statutory carbon targets will add to energy bills in the future, though with potential to offset much of this through energy efficiency. Electricity generation will need to shift from fossil fuels to low-carbon alternatives such as renewables and nuclear, which are currently more expensive. Their deployment is at present being supported through government policies that pass costs through to energy consumers and therefore increase energy bills, in particular electricity bills. We estimate an increase in the typical household bill due to these policies of 55 between 2013 and 2020, and a further 75 by Estimates of future energy prices are inherently uncertain. Policy costs for supporting low-carbon generation will depend on future gas and carbon prices, amongst other factors. Investment in low-carbon generation provides a form of insurance against future gas and carbon prices. The costs of financial support for low-carbon generation will be at their highest when overall bills are lowest and at their lowest when overall bills are highest. Energy efficiency opportunities, if fully implemented, would result in cost savings that would offset most of the additional costs when averaged across all households, and partially offset them in the commercial and industrial sectors. However, for individual households or businesses the potential for savings will differ from the average and their realisation will depend on effective design and implementation of energy efficiency policies. 4 Energy prices and bills impacts of meeting carbon budgets

6 For some energy consumers, especially the fuel poor and energy-intensive industries, government support may be needed to compensate for some of the price impacts. For fuel poor households, support is likely to be needed beyond existing energy efficiency schemes, including specific targeting of low-carbon heat measures. For industry, the Government has already put a compensation package in place which is likely to be sufficient through to Box 1: Our approach to estimating energy prices and bills Typical dual-fuel household: We focus on the 87% of UK households that use gas for heating and electricity for lighting and appliances. To estimate the consumption of a typical dual-fuel household, we use 2013 energy consumption figures from statistics published by the Department for Energy and Climate Change (DECC). We provide separate analysis for the 7% of households who use electricity for heating. Commercial sector: We distinguish between those firms covered by different low-carbon policies (i.e. the Climate Change Levy and the CRC Energy Efficiency Scheme) and with different shares of spend on gas and electricity. Industry: We estimate energy cost impacts for the sector average, as well as energy-intensive and non-intensive users. We also look at the impact that compensation and exemption from the cost of supporting low-carbon investment will have for at risk energy-intensive sectors. Central estimates: There is considerable uncertainty over future gas and carbon prices. We use DECC projections. In a central case, these have gas prices increasing from 54p/therm in 2013 to 75p/therm in We also assume the total carbon price (EU ETS and carbon price support) rises from 7 to 76/tCO 2, consistent with DECC assumptions. We separately consider the range around these central assumptions. Price base: For our backward-looking assessment from 2004 to 2013, we express energy prices and bills in nominal terms. Changes over that period can then be compared with the GDP deflator, a measure of price inflation across the economy as a whole, which increased 23%. For households, the consumer price index rose by 29% over the same period. For our estimates to 2020 and 2030, prices and bills are expressed in constant terms, at 2013 prices. Our key findings for households and businesses are set out below. Households The annual bill for a typical dual-fuel household was 1,140 in On central estimates, the bill will fall to 1,100 in 2020 and then rise to 1,305 in While low-carbon policy costs (made up of support for low-carbon electricity generation and the carbon price) rise to 2020 and 2030, wholesale costs decrease to 2020 but then rise again during the 2020s (Table 1). Our central estimate is that low-carbon policy costs increase by 55 between 2013 and 2020, and a further 75 by The total cost of low-carbon policies in 2030 would be about 175 out of a total annual household energy bill of 1,305. To 2020, the main driver of the increase is direct support for low-carbon generation. The increase from 2020 to 2030 is driven by the assumed rise in the carbon price. Depending on assumptions about gas and carbon prices, we estimate that low-carbon policy costs could range between 70 and 120 in 2020 and from 115 to 235 in There is scope for the additional impacts of low-carbon generation policy costs to be offset by savings through energy efficiency opportunities, up to 210 per year in This will rely on take-up by households. 5

7 By 2030, we expect most electricity generation to come from low-carbon sources. Energy prices and bills should then fall, as support payments for existing low-carbon generation begin to expire. Furthermore, new capacity can be added at lower cost following commercialisation of emerging technologies during the 2020s. By contrast, if the sector does not decarbonise in the 2020s, bills would continue to rise beyond 2030 with increases in the carbon price consistent with international action to avoid dangerous climate change. Table 1: Central estimate for typical dual-fuel household energy bills (in 2013) Wholesale, transmission, distribution 1, ,090 Direct low-carbon support Carbon price Energy Company Obligation 3, Warm Home Discount and smart meter support Total energy bill for typical dual-fuel household 1,140 1,100 1,305 Potential for energy efficiency savings Notes: Numbers are rounded. All numbers include VAT. We assume constant consumption of 3,000 kwh for electricity, 14,100 kwh for gas. 1 Includes the Renewables Obligation, Feed In Tariffs, Contracts for Difference, and balancing costs associated with renewables. 2 Carbon price including EU ETS and carbon price support, rising from 7 in 2013 to 76 tco2in Funding for the ECO is assumed to stay constant between 2013 and Smart meters are expected to provide a reduction in network costs by Around 7% of households use electricity as the main source for heating. These are mostly smaller properties, in particular flats, with a large proportion in the rental sector and relatively high numbers in fuel poverty. As the costs of support for low-carbon investment is currently passed through the electricity bill, these households pay a higher proportion of their energy bill towards low-carbon policy costs than dual-fuel households. In 2013, the bill for a typical electrically-heated household 1 was 925, 90 of which was for support for low-carbon generation. We estimate, using central assumptions, that this element of low-carbon support will increase to 210 in 2020 and 360 in 2030, out of a total bill of 1,255. Electrically-heated households able to switch to low-carbon heat systems, such as heat pumps, can reduce their energy bills. Energy prices are a key driver of fuel poverty. In principle, energy efficiency and low-carbon heat measures included in our carbon budgets scenarios can more than compensate for increases in energy prices due to support for low-carbon generation. However, this will require additional policies and a focus on effective targeting of measures to fuel poor households. There is also some geographical variation in levels of fuel poverty across the UK. Some households in the devolved administrations (for example, in the North of Scotland) already face higher bills than the UK average due to higher electricity prices, higher heating demand and a high prevalence of electric heating. This is reflected in higher than average levels of fuel poverty. The devolved governments already have policies in place to address fuel poverty but further support may be required. 1 As these are smaller properties, typical energy consumption is lower than in dual-fuel households. We use electricity consumption of 7,800 kwh, compared to 3,000 kwh for electricity and 14,100 kwh for gas in dual-fuel households, based on analysis by Ofgem. 6 Energy prices and bills impacts of meeting carbon budgets

8 Commercial and industrial users Currently, low-carbon policies account for an average of 26% of commercial energy sector bills and 13% of industry sector bills, with higher costs for energy-intensive users. These costs will also rise but it is harder to quantify the impact on bills given the diversity within these sectors. We project low-carbon policies to increase average commercial sector energy bills between 2013 and 2030 between 15% and 48%, with a central estimate of 31%. For industry, we estimate an average increase by 2030 of between 14% and 38%, with a central estimate of 26% (Table 2). There are opportunities for energy efficiency improvement to offset part of these impacts. Energy costs are likely to remain a small component of total costs: under 1% of costs in the commercial sector and under 3% of costs for industry on average. The impact on total costs and final prices of goods and services will therefore be small on average. For some sectors, where energy costs are a higher proportion of total costs, the impact, in the absence of compensating measures, would be more significant. Increasing electricity prices imply potential competitiveness risks for electro-intensive industries which are subject to international competition and face higher energy costs relative to competitor countries. To offset these impacts, the Government has put in place an initial compensation package and has plans for further measures for sectors at risk. Our analysis suggests this package is likely to be sufficient through to Beyond 2020, continuing support may be required depending on the scale of measures taken in other countries. Table 2: Central estimate for changes in energy bills due to low-carbon policy costs for businesses and industry (2013 to 2020 and 2030) Industry (sector average, without compensation and exemptions) 11% 26% Commercial sector (sector average CRC) 14% 31% Note: For fixed level of consumption based on Industry sector average assumes no compensation or exemption, and it does not include cost of EU ETS allowances purchases. Electro-intensive industry eligible for compensation will not experience these levels of increase. Report outline We set out the analysis that underpins these messages in four sections: 1. Estimating the impact of carbon budgets on energy prices 2. Household energy bills 3. Commercial sector energy bills 4. Industrial energy bills 7

9 1 Estimating the impact of carbon budgets on energy prices The Climate Change Act sets a long-term target of at least an 80% reduction in greenhouse gas emissions by 2050 on 1990 levels. To date, four carbon budgets up to 2027 have been legislated on a pathway to that target. Emissions in 2013 were 28% below 1990 and the first carbon budget ( ) was met. This report sets out our best estimate of how policies to reduce emissions 1 affect current energy bills, and how they can be expected to affect future bills as legislated carbon budgets are met. It updates our previous analysis (published in December 2011, updated in December 2012). Since then, there have been a number of changes that have implications for both current and future bills (Box 1.1). Box 1.1: Changes since our 2012 assessment of carbon budget impacts We have previously published analysis of the impact of carbon budgets on energy prices and bills (December 2011 and updated in December 2012). In this report, we have taken account of new fossil fuel and carbon price projections, updated estimates of grid costs and supplier operating costs and margins. We also have used a lower estimate of household energy demand, based on recent DECC energy statistics. DECC s central projections for wholesale gas prices and carbon prices are lower than they were in 2012 (in 2013). The wholesale gas price projection for 2020 has fallen from 73 p/therm to 59 p/therm. The carbon price projection has fallen from 31 to 23 per tonne of CO 2 in 2020, reflecting the Government s decision to freeze the carbon price support 2, and a lower projection of the price of carbon allowances in the Emissions Trading System (ETS). Ofgem s estimates of the costs of maintaining the grid have increased by 23% for electricity and decreased by 16% for gas between 2011 and 2013, Supplier margins have increased in the residential sector from 1% in 2011 to 3% in 2013 for electricity and remained at around 4% for gas over the same period (after increasing to 6% in 2012). Household electricity and gas demand (allowing for differences in temperatures between years) fell by around 4% between 2011 and 2013, due to improvements in household energy efficiency, higher energy prices and the impact of the recession (see Chapter 2). We have also updated our scenarios for the delivery of low-carbon generation in 2020 to include, for example, lower deployment of Carbon Capture and Storage (we now assume two demonstration projects instead of four), as set out in our 2014 progress report to Parliament. Our new estimates of impacts in 2020 allow for these changes. We also extend the period considered to 2030, in preparation for our advice on the 5th carbon budget ( ) to be delivered in December Although there are multiple ways of meeting carbon budgets, the policy costs assumed in this analysis are consistent with meeting carbon budgets in the way suggested by the CCC s progress report indicators. For example, see CCC (2014) Meeting Carbon Budgets 2014 Progress report to Parliament. Available at: 2 We assume the carbon price freeze continues until 2020, rising thereafter. While freezing the carbon price support may result in more coal being burnt in the UK in the short term, this will not increase overall EU emissions given that these are capped in the EU ETS 8 Energy prices and bills impacts of meeting carbon budgets

10 Low-carbon policy costs are currently: 16% of electricity prices in the residential sector, 26% in the commercial sector, 22% in industry. Energy prices have increased since 2004, predominantly because of increases in the wholesale gas price. As in our 2011 and 2012 reports, we conclude that whilst all energy users have experienced large increases in both electricity and gas prices since 2004, the majority of this change is unrelated to low-carbon policies. In 2030, based on central estimates, we anticipate that low-carbon policy costs will be 33% of the electricity price for households, and 46% for the commercial sector. For industry, policy costs could be 49% of the electricity price, although for energy-intensive users this does not take into account exemptions and compensation. We present our analysis in four chapters. In this chapter, we set out the method underpinning our analysis of how energy prices will affect each sector in four sections: 1.1 Power sector decarbonisation 1.2 Assessing the impact of low-carbon and other polices on current energy prices 1.3 Changes in energy prices from 2004 to Outlook for energy prices to 2030 In Chapters 2-4 we discuss how this can be expected to feed through to energy bills in the residential, commercial and industrial sectors, alongside opportunities to offset these increases through improvements in energy efficiency. 1.1 Power sector decarbonisation Power sector decarbonisation, that is, shifting electricity generation from unabated fossil fuel combustion to low-carbon alternatives such as renewables, is of key importance for meeting carbon budgets: Decarbonisation through investment in a portfolio of low-carbon technologies is a low-regrets strategy with potentially significant benefits in a carbon-constrained world. Low-carbon technologies for the power sector are available which are or are likely to become cost-effective (i.e. cheaper than fossil fuel generation facing a rising carbon price). Early decarbonisation of the power sector is central to economy-wide decarbonisation because low-carbon electricity offers a route to decarbonisation of other sectors. Our scenarios for meeting carbon budgets assume that heat pumps and electric vehicles will play an increasingly important role. 9

11 As low-carbon generation options are currently more expensive than unabated fossil-fuelled plants (i.e. gas and coal plants without Carbon Capture and Storage CCS) 3, their use will increase the cost of energy. Offsetting these increased costs, there are opportunities for energy efficiency which can cut energy bills and may provide savings larger than those costs. Our analysis is based on the current and possible future mix of low-carbon policies, allowing for how policy costs will have to change under scenarios that we have identified as being consistent with the legislated carbon budgets. 4 Whilst other scenarios could also meet the budgets, the expected costs are likely to be similar, given that all scenarios involve decarbonisation of the power sector by The Department of Energy and Climate Change (DECC) has recently published its own assessment of how Government policies affect energy bills. Although there are differences between their approach and ours, the key assumptions underpinning both assessments are comparable (Chapter 2, Box 2.3). We have a statutory duty to take into account economic and social circumstances when considering our advice in relation to carbon budgets, and this includes impacts on competitiveness and fuel poverty. It is important therefore for us to set out our views of these impacts. 1.2 Assessing the impact of low-carbon and other policies on current energy prices Retail prices faced by customers pay for energy delivered and available at the point of consumption (i.e. in the home or the workplace). Prices reflect the costs of producing, transporting and supplying energy, including supplier margins, as well as policy costs faced by energy generators and suppliers. We focus on the standard unit of price per kwh 5. A typical dual-fuel household uses around 3,000 kwh of electricity annually for lighting and appliances, and just over 14,000 kwh of gas for space heating and water heating 6. Energy prices in the commercial and industrial sectors are lower than for households (Table 1.1, Figure 1.1), reflecting lower costs of supply (e.g. through higher load factors which allow better utilisation of infrastructure). As large bulk purchasers of energy, some commercial and industrial consumers may also be able to negotiate lower prices. The historical prices presented in this report are in the money of the day (i.e. nominal); all 2013 and future prices are in 2013 money (i.e. real). 3 Our evidence suggests that the costs of economy-wide decarbonisation are dominated by costs in the power sector. For example, in our 2010 analysis on the Fourth Carbon Budget we identified a total cost of meeting the budget of 0-0.6% of GDP, and a cost of power sector decarbonisation of 0-0.5%. 4 Specifically, we base our analysis on scenarios set out in our 2014 progress report to Parliament and our 2013 review of the Fourth Carbon Budget. 4 We assume the carbon price freeze continues until 2020, rising thereafter. While freezing the carbon price support may result in more coal being burnt in the UK in the short term, this will not increase overall EU emissions given that these are capped in the EU ETS. 5 One kwh is enough electricity to boil a full kettle around 6 times or run a washing machine cycle. 6 Consumption estimated for a typical, dual fuel customer using estimates of energy consumption from DECC (2014) Energy Consumption in the United Kingdom. 10 Energy prices and bills impacts of meeting carbon budgets

12 Table 1.1: Gas and electricity prices, by sector, 2013 Gas p/kwh Electricity p/kwh Households Commercial Industry Notes: All costs in Source: DECC (2014) Quarterly Energy Prices September Available at: In the residential sector, the majority of the electricity and gas price (80% and 89% in 2013) reflects wholesale, supplier and network costs (i.e. transmission, distribution and metering TDM): Wholesale costs (i.e. the costs of buying electricity from generators) made up 6.0 p/kwh (39%) of the residential retail electricity price and 2.6 p/kwh (53%) of the gas price. Other costs faced by suppliers and their margins made up 2.4 p/kwh (16%) of the retail electricity price and 0.8 p/kwh (17%) of the gas price. Transmission and distribution costs (i.e. the costs of installing, refurbishing and upgrading the networks of gas pipes and electricity wires) made up 2.9 p/kwh (19%) of the residential electricity price and 0.9 p/kwh (18%) of the gas price. These costs are regulated by Ofgem. Other costs in the electricity price include 0.7 p/kwh for the costs of balancing 7 (5%), and 0.1 p/kwh (1%) for metering. In addition, final energy prices include the impact of a number of low-carbon, fiscal and social policies (Table 1.2) which we set out in more detail below. Figure 1.1: Average gas and electricity prices in the residential, commercial and industrial sectors (2013) 16 VAT 14 CRC Energy Efficiency Scheme p/kwh (2013 prices) Residential Commercial Industrial Residential Commercial Industrial Electricity Gas Climate Change Levy (average paid after Climate Change Agreement discounts) Smart meters Energy efficiency measures Warm Home Discount Renewables - intermittency Renewables Carbon price Wholesale, transmission, distribution and metering Source: CCC Calculations. 7 System balancing is required to ensure that the generation of electricity matches the demand for electricity in real time. The responsibility of balancing the electricity grid lies with National Grid, as the System Operator (SO), and incurs additional costs in the form of payments to backup and standby generation plant. In 2013, balancing costs known as Balancing Use of System Service charges (BSUoS) are estimated at 0.7p/kWh for residential consumers. 11

13 Table 1.2: Key factors affecting electricity prices ( ) Base electricity price Wholesale electricity price 3.4 p/kwh 6.0 p/kwh 5.1 p/kwh 6.1 p/kwh Transmission & distribution costs 6 bn 8 bn 8 bn 8 bn Supplier margins: Residential (commercial and industrial sectors) 0% c. 3% (6%) c. 3% (5%) (Average ) Low-carbon policy costs Carbon price N/A 7/tCO 2 23/tCO 2 76/tCO 2 Direct low-carbon support 0.5 bn 3.3 bn 7.2 bn 10 bn Energy taxes (commercial and industry only) Climate Change Levy (CCL) Carbon Reduction Commitment (CRC), CCL CRC, CCL CRC, CCL Other costs Energy Company Obligation (households only) 0.2 bn 1.4 bn 1.4 bn 1.4 bn Notes: All costs in See chapters 3 and 4 for assumptions regarding CCL and CRC. The impact of coal prices on the base electricity price is not considered as in recent years gas plant has been the marginal plant in the electricity market, thus setting the price of electricity. In future years our scenarios include a decreasing amount of coal generation on the system. The wholesale electricity price is based on outturn data for 2004 and 2013 (i.e. reflecting a mix of generation plant); projected wholesale electricity price assumes new gas generation and a gas price of 59 p/therm in 2020 and 75 p/therm in Scenarios include gas price +/- 30p/therm; carbon price +/- 20/tCO2 in 2020, +/- 40/tCO2 in Source: DECC (2014) Fossil Fuel Price Projections, DECC (2014) Updated short-term traded sector carbon values for policy appraisal, Ofgem (2014) Supply Market Indicators. The impact of low-carbon policies and other policy costs The cost of supporting low-carbon electricity generation is paid through electricity bills, and currently adds around 1.5 p/kwh to electricity prices for all users (Table 1.3). This currently accounts for 16% of electricity prices in the residential sector, which compares to 26% and 22% in the commercial and industrial sectors. Carbon price. Generators face a carbon price of 7 per tonne of CO 2 emitted in 2013 under the EU Emissions Trading System and the UK s carbon price support. The carbon price raised around 0.9 billion in revenue for the Exchequer in Direct support for renewable generation. Further support is paid to renewable generators through the Renewable Obligation (RO) and Feed-In-Tariffs (FITs) for small-scale generators. Higher levels of intermittency associated with an increased proportion of renewables on the grid also impose costs, which we include: Renewable generators currently provide 16% of UK generation (51TWh), around 90% of which is supported by the RO and FITs, The total spending for this support is capped under the Levy Control Framework (LCF) 8, for which the limit was 3.3 billion in 2013/14, The costs are recovered from all electricity consumers. 8 The Levy Control Framework put a limit on the total spending to cover the following policies: the Renewables Obligation (RO), Feed-in Tariffs (FiTs), Warm Home Discount, and Contracts for Difference (CfDs). 12 Energy prices and bills impacts of meeting carbon budgets

14 Businesses and households also face other policy costs, as well as a range of taxes. Some of these have an element of supporting emission reductions, while others are aimed primarily at meeting social and/or fiscal objectives: Funding for energy efficiency (households only). Energy suppliers are obligated to fund energy efficiency improvements in households under the Energy Company Obligation (ECO). Some of this funding is aimed specifically at reducing carbon emissions, some primarily at reducing fuel bills for low-income households (for further detail see Chapter 2). Costs are recovered from almost all household gas and electricity bills 9. Warm Home Discount (households only). This provides a rebate to low-income households on their energy bills, with costs recovered from all households (see Chapter 2). Smart meters (households only). The Government has set a target to install smart meters in all homes and 2 million businesses between 2013 and Suppliers recover this cost from households is the first year this cost is being paid. Energy taxes (businesses only). Businesses and industry pay towards both the Carbon Reduction Commitment (CRC) and the Climate Change Levy (CCL). The CRC and CCL provide around 1.4 billion per annum in fiscal revenue. VAT. Households pay a reduced rate of VAT of 5%. As businesses pay VAT but can fully reclaim it, we do not include this in our analysis for the industrial and commercial sectors. For the residential sector, we split out the VAT related to low carbon support, which was less than 0.1 p/kwh of the 0.7 p/kwh VAT on the electricity price in The ECO applies to energy companies that have more than 250,000 domestic customers and provide more than 400 gigawatt hours of electricity or more than 2,000 gigawatt hours of gas to these customers. 13

15 Table 1.3: Policy costs paid through energy prices in 2013 Residential Commercial (medium user covered by CRC) Industrial (average user) p/kwh Electricity Gas Electricity Gas Electricity Gas Direct support for low-carbon generation Carbon price Assumed costs of integrating and managing low-carbon generation ECO Smart meters Warm Home Discount CRC CCL VAT TOTAL Source: CCC calculations. Information for the year-to-date in 2014 suggests that prices will be slightly higher than in 2013 (by around 5% for gas and 6% for electricity). This reflects higher supplier margins, metering and grid costs, partially offset by lower wholesale costs and the ECO. It also reflects the package of measures announced in December 2013 to reduce bills for households by 50 on average from 2014, including a reduction in funding for the ECO and a 12 electricity rebate. Chapters 2-4 set out how prices are reflected in energy bills in each sector. 1.3 Changes in energy prices from 2004 to 2013 The average retail electricity price faced by households increased from 7.5 p/kwh in 2004 to 15.1 p/kwh in 2013 (i.e. a 102% increase compared to general price inflation of 23% over this period). Wholesale, supplier and TDM: The wholesale price (which includes supplier costs and margins, as well as the wholesale cost of fuels used in generation) increased by 3.7 p/kwh between 2004 and A further 0.9 p/kwh increase reflects TDM and balancing costs. Carbon price. The introduction of carbon pricing from 2005, which reached a level of 7 per tonne of CO 2 in 2013, increased electricity prices by 0.4 p/kwh. 10 We assume costs of managing intermittent generation in line with Pöyry s work for our 2011 Renewable Energy Review, of 1p/kWh per additional unit of renewable generation. See Pöyry (2011) Analysing technical constraints on renewable generation to Available at 14 Energy prices and bills impacts of meeting carbon budgets

16 Support for low-carbon investment: Support for low-carbon generation through the Renewables Obligation (RO) and Feed-In-Tariffs (FITs) added 1.0 p/kwh to the electricity price. This support has helped incentivise an increase in the share of renewable electricity generation from 4% in 2004 to 16% in Energy efficiency funding: The UK has operated energy supplier obligations to fund energy efficiency schemes since 1994, with the costs passed through to household gas and electricity bills. In 2004, under the Energy Efficiency Commitment, costs were an estimated 0.02 p/kwh on gas and 0.07 p/kwh on electricity. In 2008 and 2009, more ambitious energy efficiency targets were introduced under the Carbon Emissions Reduction Target (CERT) and the Community Energy Saving Programme (CESP), increasing the costs to 0.22 p/kwh on gas and 0.65 p/kwh on electricity. This level of support was maintained under the ECO, which was introduced in Recent changes to reduce the ambition of the ECO and associated costs only came into effect in 2014, so do not affect our 2013 prices. Smart Meters: The rollout of smart meters to residential electricity and gas consumers, and two million small businesses in the UK is estimated to have added 0.02 p/kwh to residential electricity and gas prices between 2004 and Other policies: The introduction of the Warm Home Discount in 2011, which provides a fuel rebate for eligible low-income and vulnerable householders of around 120 a year, increased the 2013 electricity price by 0.2 p/kwh and the gas price by 0.04 p/kwh. VAT is 5% of the electricity price; in 2013 this was 0.7 p/kwh. Commercial sector electricity prices increased from 3.9 p/kwh in 2004 to 10.1 p/kwh in 2013 and industrial electricity prices rose from 3.3 p/kwh to 8.1 p/kwh in 2013 (Figure 1.2): Wholesale, supplier and TDM: The wholesale electricity price (including supplier operating costs and margins, and network costs) for commercial consumers increased by 4.1 p/kwh, from 3.3 p/kwh to 7.4 p/kwh, and increased by 3.3 p/kwh for industrial consumers, from 3.0 p/kwh to 6.3 p/kwh. Support for low-carbon investment and carbon price: As set out above, the p/kwh impact of low carbon policies are the same for households and businesses (notwithstanding that households pay VAT). Energy taxes: The CRC added 0.6 p/kwh in the commercial sector and 0.1 p/kwh in the industrial sector in The CCL increased from 0.4 p/kwh to 0.5 p/kwh for the commercial sector between 2004 and It fell from 0.2 p/kwh to 0.1 p/kwh in industry on average, given increased discounts for sectors that have a Climate Change Agreement (see Chapter 4). 15

17 Figure 1.2: Retail electricity prices from 2004 to 2013 (residential, commercial and industrial sectors) 16 VAT p/kwh (nominal prices) Residential Commercial Industrial Climate Change Levy (average paid after Climate Change Agreement discounts) CRC Energy Efficiency Scheme Smart Meters Warm Home Discount Energy efficiency measures Renewables and intermittency Carbon Price Wholesale, transmission, distribution and metering Note: Inflation over this period was 23% Source: CCC Calculations. Retail gas prices have more than doubled from 2004 to 2013, almost entirely due to factors unrelated to policies for meeting carbon budgets: Residential gas prices have increased from 1.9 p/kwh in 2004 to 4.9 p/kwh in 2013 (i.e. by 161%). 1.3 p/kwh of the increase was the result of the rising international wholesale price of gas, alongside a 0.4p/kWh increase in network costs, and 0.9p/kWh of the increase was the result of an increase in supplier costs and margins. Increased funding for energy efficiency (i.e. CERT and ECO) added 0.2 p/kwh, while the early roll-out of smart meters added less than 0.1 p/kwh. VAT is 5% of the gas price; in 2013 this was 0.2 p/kwh. Commercial gas prices have increased from 1.3 p/kwh to 3.3 p/kwh. Most of this is unrelated to low-carbon policy. The wholesale price of gas increased by 1.3 p/kwh over this period, alongside an increase of approximately 0.4 p/kwh in transmission and distribution costs. A 0.2 p/kwh increase reflects the introduction of the CRC. Gas prices in the industrial sector have increased from 1.0 p/kwh to 2.7 p/kwh, the majority of which was due to an increase in the wholesale price of gas of 1.3 p/kwh, with the remainder from increased supplier costs and margins, network costs and policy costs under the CRC and CCL. Offsetting these price increases, there have been considerable improvements in the energy efficiency of boilers, lights and appliances since As a result, the cost of energy services has not increased as much as energy prices and in some cases has actually fallen (see Chapter 2). As in our 2011 and 2012 reports, we conclude that whilst all energy users have experienced large increases in both electricity and gas prices since 2004, the majority of this change is unrelated to low-carbon policies. We now turn to the outlook for energy prices and the potential impact of low-carbon policies out to Energy prices and bills impacts of meeting carbon budgets

18 1.4 Outlook for energy prices to 2030 (a) The impact of power sector decarbonisation on future electricity prices Our assessment assumes the balance of policies remains roughly as currently planned (i.e. with the bulk of the costs of decarbonisation falling on electricity bills) and additional funding in areas where we have assessed this is necessary to meet carbon budgets. Given its cost-effectiveness and importance in the economy-wide decarbonisation strategy, we have advised the Government that the UK should aim for early decarbonisation of the power sector. This would involve reducing sector carbon intensity from its current level of around 500 gco 2/kWh to gco 2/kWh by 2030 through a portfolio of low-carbon options (i.e. renewables, nuclear and carbon capture and storage CCS). UK electricity generation had a carbon intensity of around 500 gco 2/kWh in 2013, although our analysis has shown that the emissions intensity at which the current UK installed capacity mix is capable of operating has reduced from 460 gco 2/kWh in 2007 to under 300 gco 2/kWh in Actual grid intensity is expected to fall to under 300 gco 2/kWh by 2020, as the UK deploys renewable generation as required by the EU Renewable Energy Directive. The Government has also agreed to support at least two CCS demonstration plants by 2020; the White Rose project in Yorkshire and at Peterhead in Scotland. We have identified that to meet carbon budgets cost-effectively, the UK should deploy a portfolio of low-carbon generation options through the 2020s, including renewables, nuclear, and CCS applied to coal and gas plants. To achieve this decarbonisation of the power sector, current and planned policies are likely to increase electricity prices in real terms: Carbon price. While the EU ETS price is likely to remain low to 2020 given the current surplus of allowances (Chapter 4), the Government has announced increases in the UK s carbon price support to 2015/16 after which it will be frozen. In the longer term, higher carbon prices are likely to be needed under international efforts aiming to limit global temperature increases to 2 degrees above pre-industrial levels. We therefore follow the approach based on the Government s estimated carbon values and assume a carbon price that increases from 7 per tonne CO 2 in 2013 to 23 per tonne CO 2 in 2020 and 76 CO 2 in This would increase the impact on electricity prices from 0.4 p/kwh 12 in 2013 to 0.8 p/kwh in 2020 and 2.7 p/kwh in CCC (2014) Meeting Carbon Budgets 2014 Progress Report to Parliament. Available at: The emissions intensity of the grid at any point in time depends upon the relative economics of coal and gas. However, if in 2013 the grid had been operated to minimise emissions (i.e. running gas before coal), the emissions intensity could have fallen to around 300 g/kwh. 12 We assume new gas generation to be the marginal plant in the electricity system between 2020 and 2030, at a carbon intensity of 350 gco 2/kWh. 17

19 Direct support for low-carbon generation. The Government has allocated 7.8 billion of annual funding 13 for low-carbon generation in 2020 under the Levy Control Framework. This would be sufficient to increase renewable generation from 16% in 2013 to 30-35% in 2020, while funding at least two CCS demonstration projects. After 2020, we assume that funding continues to support the transition to a low-carbon power sector, such that the impact on electricity prices increases from 1.1 p/kwh in 2013 to 2.4 p/kwh in 2020 and 2.9 p/kwh in 2030 (including direct support for low-carbon generation, additional transmission and managing intermittency, see Box 1.2). We assume that these increased costs affect all electricity used by households and the commercial sector, given they are recouped from suppliers on a per unit basis. Some energy-intensive industrial users are exempted from or compensated for these costs, and will not be exposed to the increases to avoid competitiveness risks (Chapter 4). These exemptions will increase the costs of supporting low-carbon investment for non-exempt consumers, although this impact is expected to be small (up to around 5 on household bills). Box 1.2: Estimating the cost of supporting low-carbon generation Our calculations around the level of support required for low-carbon generation are based on reaching a decarbonisation target of gco 2/kWh in For example, a 50 gco 2/kWh scenario could include around 6 GW CCS, 24 GW of each of onshore and offshore wind, as well as 17 GW of nuclear. We assume that 100 gco 2/kWh would be delivered at a similar cost given that higher carbon intensity would ensue either because the costs of low-carbon technologies are higher, or because cheaper low-carbon technologies face deployment constraints. Direct support for low-carbon generation is provided through Feed-In-Tariffs (FITs) for small-scale low-carbon generation, the Renewables Obligation (RO) up to 2016/17 and Contracts for Difference (CfDs) from 2014/ The cost of this support is recovered through energy bills, limited by the Levy Control Framework (LCF). In a central case, we estimate the funding required to directly support low-carbon generation to be around 7.2 bn in 2020 and 10 bn in and falling thereafter (peaking at 11 bn in 2027), in order to meet carbon budgets. These costs are spread over consumption, resulting in price impacts of 2.1 p/kwh in 2020 and 2.6 p/kwh in : FITs: We assume projected spend in the 2020s to remain in line with DECC s projected level for 2020 of 1.2 bn 17. RO: We assume that the RO peaks at 3.1 bn per annum in In the 2020s and beyond, as older projects that were installed under the RO come to the end of their 20 year lifetime, the total spend under the RO falls. CfDs: We assume all projects beyond 2015 opt for the CfD (rather than the RO) at costs in line with DECC s published strike prices 18. Beyond 2020, we assume strike prices in line with Pöyry s 2013 assessment 19 for our 2013 report Next steps on Electricity Market Reform. Further costs are also incurred for integrating and managing low-carbon generation in the grid, for example from higher transmission costs arising from connecting geographically-remote renewable generation, as well as additional costs for backup capacity for intermittent renewables bn in 2011/12 prices. 14 The cost determined by the difference between the agreed strike price and the cost of gas generation facing a carbon price. In practice, developers will see a return under Electricity Market Reform (EMR) equal to the difference between the strike price and the market wholesale price (with a specific price index, e.g. day-ahead for renewables). 15 As set out in CCC (2013) Next Steps on Electricity Market Reform, using the long-run marginal cost of gas generation as the price index is a better reflection of the costs to consumers than the projected wholesale price. We estimate the cost of gas generation facing a carbon price to be around 60/MWh in 2020 and 90/MWh in In CCC (2013) Fourth Carbon Budget Review, our scenarios project rising electricity consumption, from 316TWh in 2013 to 435TWh by This is in part due to low-carbon electric technologies such as heat pumps and electric vehicles. 17 DECC (2014) Annual Energy Statement Available at: This is an increase of 450m since our previous report. 18 DECC (2013) Final Delivery Plan for EMR. Available at: 19 Pöyry (2013) Technology Supply Curves for Low Carbon Generation. Available at: 20 Pöyry (2011) Analysing technical constraints on renewable generation. Available at: 18 Energy prices and bills impacts of meeting carbon budgets

20 Box 1.2: Estimating the cost of supporting low-carbon generation Additional transmission: 0.2 p/kwh to cover additional transmission assets as identified by the Electricity Networks Strategy Group 21, equivalent to a total cost of 9 bn annualised over the lifetime of the asset. Managing intermittency: 0.1 p/kwh for the cost of managing intermittency in 2013, based on analysis by Pöyry (2011) for our 2011 Renewable Energy Review. This cost increases over time with penetration of intermittent renewables. These increases are included in our estimates of strike prices, which assume generators effectively face these costs. (b) Funding for energy efficiency and other policy costs Our scenarios for meeting carbon budgets imply continuing improvements in energy efficiency in all sectors to 2030 and beyond. For example, in homes we assume the insulation of all lofts and cavity walls by 2022 and 3.5 million solid walls by 2030, alongside a number of lower-cost measures such as draught-proofing. Some of these improvements will save more money over their life than the upfront costs involved and are likely to be financed by homeowners themselves, potentially using the Green Deal. Others will require additional funding, and some will require full funding of the capital costs (e.g. to support action addressing fuel poverty), which may be levied on bills for residential consumers. We assume that most policy costs would stay constant to 2030, with the exception of smart meter costs which only run to 2020, and by 2030 would deliver saving in network costs. Energy efficiency funding. Funding under the ECO in 2013 was 1.4 bn. We estimate this to be enough to incentivise the annual uptake of insulation measures in our carbon budget scenarios. We therefore assume no change in the price impact of ECO funding from 2013 to 2020 or This assumption implies an increase in funding from the reduced level of ambition for the ECO that the Government has introduced in 2014, but no increase relative to Warm Home Discount. We have not applied a cost for the Warm Home Discount in 2020 and 2030, as currently the policy is only committed to until Funding for fuel poverty. Further funding may be required to address fuel poverty but we assume this would be paid through general taxation rather than energy bills (see Chapter 2). Smart meters. DECC estimates that the net costs, not accounting for energy savings, of the programme will add 0.01 p/kwh to household electricity prices and 0.02 p/kwh to household gas prices from 2013 to By 2030, by which time the installation programme will be complete, smart meters will reduce costs due to savings in network and metering costs (by 0.07 p/kwh on electricity and 0.10 p/kwh on gas). We assume that VAT continues at 5% and the CCL is maintained at its current level in real terms. 21 ENSG (2012) Our Electricity Transmission Network: A Vision for Available at: 19

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